irr m users summary

7/28/2019 Irr m Users Summary

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Interest Rate Risk Monitor: Introduction and Overview


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InterestRateRiskMonitor(IRRM)An

Introduction

and

Overview

INTENDEDFORINSTITUTIONALINVESTORSONLY. Thedataprovidedinthesereportsisforinformationalpurposesonlyandisintendedsolelyforyourprivateuse.InformationhereinisbelievedtobereliablebutTheBakerGroupLPdoesnotguaranteeitscompletenessoraccuracy.Opinionsconstituteourjudgmentandaresubjecttochangewithoutnotice.Pastperformanceisnotindicativeoffutureresults.Theinvestmentsandstrategiesdiscussedheremaynotbesuitableforallinvestors;ifyouhaveanydoubtsyoushouldconsultyourBakerrepresentative.Theinvestmentsdiscussedmayfluctuateinpriceorvalue.Changesinratesofexchangemayhaveanadverseeffectonthevalueofinvestments.Thismaterialisnotintendedasanofferorsolicitationforthepurchaseorsaleofanyfinancialinstruments.


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At various times, banks have had to cope with panics, recessions, depressions, deflation, and inflation to

survive and prosper. Many banks managed to adapt to changing conditions; however, many were

engulfed by the events. The survivors either anticipated or recognized the impact events would have on

the banking business. Accordingly, they established policies and procedures designed to deal effectively

with the particular situation.

Dr. James V. Baker, Jr.

Since the founding of The Baker Group in 1979, the firm remains dedicated to helping client institutions

navigate the unpredictable changes inherent in the banking industry. Most recently, community banks

have been challenged by a painful mix of historically low interest rates, unprecedented monetary policy,

and new regulatory expectations. More than ever before, banks need access to powerful tools for

modeling exposures to interest rate risk, stress testing the balance sheet, and simulating the impact of

different potential environments and market conditions. The Interest Rate Risk Monitor (IRRM) has been

designed specifically for community-banks to help them satisfy this need.

IRRM enables banks to assess and manage the future impact of

changing interest rates on profitability and equity position. It projects

earnings and volatility of equity capital under various balance sheet

and interest rate scenarios. It produces standard measures of price

risk for the entire balance sheet including modified duration, effective

duration and convexity. And it projects balances and yields per

account for 12- and 24-month budgeting purposes. Importantly, as the

regulatory environment has moved decidedly toward greater scrutiny

of interest rate risk processes, IRRM reports are designed to be fully

compliant with examiner expectations.

This users guide is intended to provide basic information about the IRRM model, interpretation of

reports, and an explanation of methodologies. Additional sections include information about data input

and assumptions, as well as specific information for directors. We hope Baker IRRM clients find it useful.


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Table of Contents

1 Asset / Liability Mix

4 Gap Measures

6 Earning Power Measures

8 Earnings Simulation

9 Economic Value of Equity (EVE)

10 Important Notes & Useful Definitions

12 Non-Maturity Deposits Analysis

14 Methodology & Capabilities

- Tax Treatment- APM Import- Liquidity Stress Tests: Cash Flow- Back Testing- Budgeting- Dynamic Simulation Capabilities19 Data Input & Assumptions

23 Basics of IRR: Primer for Directors

28 Regulatory Guidance: Interest Rate Risk


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Interest Rate Risk Monitor: Overview & Summary ALCO Reports

Interest Rate Risk Management requires proper analysis of balance sheet data in a dynamic context, and

a good reporting system is necessary for that analysis. The Interest Rate Risk Monitor (IRRM) has been

designed to satisfy the fundamental needs of a sound reporting system. The data is thorough and

detailed, but the reports are readable and useful for risk assessment and strategy development.

Separate reports are designed for the three primary constituencies who will make use of them: bank

management, bank directors, and regulatory authorities. Key reports are accompanied by descriptive

text and explanation to assist in interpretation and analysis.

Summary ALCO: This is the executive summary for a full set of IRRM reports. It provides the essential

information necessary for analysis. This includes the following reports:

Summary ALCO - A/L Mix: A snapshot of the balance sheet as of report date. This report shows

broad categories of assets and liabilities, and essential measures of those items across the

columns. Key liquidity measures are also shown on this page along with pie charts of the asset /liability mix. This page provides a starting point for understanding the interest rate risk position

of the bank. Among other things, the balances of various asset and liability categories are listed

along with the percentage of each balance that is rate sensitive (re-priceable) in the next 12

months. Existing book yields and rates are shown alongside the new reinvestment rates for

each category so users can get an idea of rate differentials for repricing balances and the

expected impact on interest income and expense.


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Liquidity Ratios - The IRRM report lists certain key liquidity ratios on the Asset / Liability Mix page. These

measures and definitions are listed below.

Investments / DepositsThe investment to deposit ratio displays the percentage of deposits used to fund investments.

Since there is an actively traded investment market, a high percentage of investments to

deposits could display a very liquid balance sheet if these securities book value was equal or

close to market value.

o Investments / Deposits = Total Securities / Total Deposits Loan / Deposits

Many banks and bank analysts monitor loan / deposit ratios as a measure of liquidity. Loans are

presumably the least liquid of assets, while deposits are the primary source of funds. A high

ratio indicates illiquidity because a bank is fully loaned up relative to its stable funding.

Implicitly, new loans or other asset purchases must be financed with large purchased liabilities,

which can be very expensive. A low ratio suggests that a bank has additional liquidity because it

can grant new loans financed with stable, low cost deposits.o Loans Category / (Non-Maturing Demand + CD > $250,000 + CD < $250,000) 100

Loans / CapitalLoans / capital displays the amount of loans versus the amount of primary capital for a particular

institution. History has shown that institutions with loan amounts equivalent to eight times tier

1 capital are testing the limits of prudence. Ratios much lower than eight times capital could be

considered the norm for most institutions. Loans / capital is derived by:

o Total Loans / Net Tier 1 Capital Net Funds Borrowed / Capital

Net funds borrowed / capital is monitored by analysts and bank managers to display the extentto which bank managers are forced to utilize purchased funds to maintain steady growth.

o ((Borrowed Funds - Funds Sold) / Capital) 100 Reliance on Wholesale Funding

o Reliance on Wholesale Funding = (Total Borrowings + Brokered Deposits) / (TotalBorrowings + Total Deposits)


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Dependency RatioThe Dependency Ratio displays the amount to which an institution's long term assets are

dependent on short term (volatile) liabilities for funding. The dependency ratio is calculated by:

o Dependency Ratio = ( ( Non-Core Liabilities - Short Term Investments ) / ( Long TermAssets * 100 ) )

Liquid Assets / Total AssetsAsset liquidity refers to the ease of converting an asset to cash with a minimum amount of loss.

The most liquid assets typically mature in the near term and are highly marketable. The liquidityratio is expressed as a percentage of total assets. The Liquidity Ratio is calculated by:

o (Cash & Due + ST Investments - Pledged Investments + Funds Sold + Trading Account) /Total Assets

o ST Investments = all investments that mature or paydown within a one year time frame.

Jumbo CDs / Total AssetsJumbo CD's, or time deposits over $250,000, typically tend to be highly volatile in that

purchasers of CD's that size tend to pay close attention to interest rates. This close monitoring

of the term structure of interest rates allows purchasers to shop around for the highest rate.

This shopping around causes this type of liability to be highly volatile money, hot money. It isvital to banks to keep large percentages of deposits from leaving the bank at one time.

Therefore, managers and analysts use this ratio to protect against runs on the bank. Over

$250m Dep. / Total Assets is calculated by:

o (Certificates of deposits of $250m or more + Open Account Time Deposits of $250m) /Total Assets

Available Line of CreditThis includes the amount of any and all borrowing lines that are currently unencumbered and

untapped by the bank. Unused lines of credit at the Federal Home Loan Bank, for example,

would be listed.

*Note: In some cases, the call report will show different measures for the same ratio seen in IRRM. This

is simply due to methodological differences in the calculations (e.g. average balance versus end-of-

period balance in the denominator of a calculation can produce notably different results.


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Effective Gap versus Repricing Gap: One of the problems with Gap measures involves the treatment of

non-maturing deposits. These liability accounts (such as Checking, Savings, and MMDA) do not have an

identifiable maturity date and contractually the rate may be changed by the bank any time it chooses.

So there arises a question as to whether these items should be treated as always and immediately rate

sensitive, or if they should be assigned a rate sensitivity that more accurately reflects their true

behavior.

Summary ALCO - Gap Measures: This report shows various measures of the rate sensitive Gap

which is simply the dollar difference between rate sensitive assets (i.e. assets that re-price or

mature) and rate sensitive liabilities for a particular time period, usually 12 months. If more assets

re-price than liabilities, the number will be positive which shows that an institution is asset

sensitive, or positively gapped. Traditional Gap theory says that an asset sensitive institution will

generally realize an increase in income if interest rates rise due to the fact that more assets than

liabilities will be rolling over and repricing into higher market rates. In this case, all else being

equal, earning asset yield will rise faster than the cost of liabilities. The exact opposite takes place

if the bank has a negative Gap, where more liabilities than assets re-price during the period. It is

important to note that Gap analysis deals only with balances of rate sensitive assets and liabilities,

and ignores the rates (yields or costs) associated with those repricing balances. It is therefore only

a crude indicator of the potential change in net income.


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Repricing Gap is defined as a gap measure that utilizes contractual repricing dates in theallocation of assets and liabilities across predefined time periods. A repricing gap treats non-

maturing deposits as though they will immediately and instantly re-price each time market rates

move. Repricing Gap does not consider the actual behavior of non-maturing deposits in terms of

how they affect the balance sheet.

Effective Gap is a more useful measure for rate sensitivity analysis. Effective gap uses behavioralassumptions that more accurately model the rate sensitivity of non-maturing deposits. Effective

Gap is considered to be the more meaningful measure for analysis since it looks at the truebehavior of non-maturing deposits rather than the contractual ability to re-price. The IRRM uses

FDICIA 305 guidelines as a default treatment of non-maturing deposits in order to arrive at the

Effective GAP.

Treatment of Non-Maturity Deposits: Most banks have a large percentage of their liabilities in core

deposits or non-maturity deposits (DDA, NOW, and MMDA). These liabilities are difficult to model with

respect to rate sensitivity and repricing behavior. The rates paid on Core deposits are generally

considered to be administered rates in the sense that they set or changed at anytime at the discretion

of bank management. Often, core deposit rates are barely moved for lengthy periods of time, but to

some degree bank managers will move these rates according to changes in the general interest rateenvironment. Every bank is different in this respect. In order to model these deposits appropriately, we

must use some sort of guidelines for estimating how rate sensitive these accounts are likely to be.

As a base case default or starting point, the IRRM may draw on the sort of guidelines originally proposed

in section 305 of the FDIC Improvement Act of 1991 (FDICIA). These guidelines provide for a percentage

of the balance in different non-maturing deposit accounts to be treated as re-priceable or rate sensitive

across a range of maturity buckets. This scheme of maturity distribution is shown in the table below.

FDICIA 305: Maturity Distribution Limits for Non-Maturity Deposits

----------------------------------------------------------------------------------------------------------------

0-3 mos 3-12 mos 1-3 yrs 3-5 yrs 5-10 yrs

(pct) (pct) (pct) (pct) (pct)

---------------------------------------------------------------------------------------------------------------

Commercial DDA.... 50 0 30 20 .....

Retail DDA............... 0 0 60 20 20

MMDA.................... 0 50 50 ..... .....

Savings.................... 0 0 60 20 20

NOW....................... 0 0 60 20 20

----------------------------------------------------------------------------------------------------------------

This treatment of non-maturity deposits will result in average life and duration measures that are

greater than zero, but still fall within reasonable ranges for analysis of economic value. It is important to

note that industry averages or guidelines may serve as a starting point, but are not intended toreplace the need for banks to evaluate and consider the unique characteristics of their individual

deposit bases when determining their rate sensitivity. IRRM clients now have a non-maturity deposits

analysis done periodically in order to more accurately reflect the behavior of their banks deposit

balances.

Note: More detail on the treatment of non-maturity deposits can be found in a supplemental section

of this report.


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YTD Annualized One method for determining the base case is to simply look at actualyear-to-date annualized performance and assume that the bank continues on the same

trajectory for the next twelve months. We are using the performance of the recent past to

project the base case for the coming year. The potential problem with this method is that

often there may have been one-time or non-recurring income or expense events that skew

the year-to-date performance. Also, many banks experience seasonality or calendar-year

patterns of performance that can introduce distortions. For banks such as these, we use analternative method for deriving the base case called the Constant Balance Sheet method.

Constant Balance Sheet This method for calculating the base case simply takes thebalances of assets and liabilities that existed on report date, applies the actual rates

associated with those balances and then does the multiplication. This method takes a

snapshot of existing (not historical) balances and rates, and extrapolates a baseline for

earnings. The base case net-interest income is just (Earning Assets Balance x Asset Yield

Summary ALCO - Earning Power Measures: This report provides several key pieces of information

about the baseline performance of the bank. Key performance ratios are shown on a YTD annualized

basis as well as a Constant Balance Sheet basis which is defined below. The establishment of a

base case of earnings is a necessary precondition to the dynamic analysis of a banks interest raterisk. Knowing that we must first establish a baseline or benchmark against which to measure

changes, we may use one of two different methods for deriving this base case.


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Paying Liabilities Balance x Liability Cost). Non-interest income and expense are plugged in

or assumed to be the actual year-to-date numbers annualized.

Earning Power Measures: Bank Earnings arise ultimately from income exceeding expenses.Various metrics exist which allow us to track the earning potential or earning power of a bank at

a point in time. For example:

o Efficiency Ratio: The efficiency ratio displays how well bank managers are utilizing thebanks resources to produce healthy returns for the shareholders. The efficiency ratiocan be thought of as total overhead expense (i.e. non-interest expense) divided by total

operating income less interest expense. The efficiency ratio is calculated by: Total

Overhead Expense / (Total Operating Income Interest Expense).

o Earning Assets / Paying Liabilities: This ratio is an earning power measure that displaysthe amount of earning assets that an institution possesses for every dollar of paying

liabilities. Equilibrium is achieved when a measure of 100 is achieved, however for an

institution to profit from business a spread should exist. In historical terms banks have

been able to maintain a level of $1.17 of earning assets for every $1.00 of paying

liabilities.

o Net Interest Margin: The net interest margin is the dollar difference between interestincome and interest expense expressed as a percentage of average assets.

Breakeven Margin: The breakeven margin is the level of net interest margin thatan institution must earn on its average earning assets in order to pay all of its

expenses. It is the level of net interest margin that produces no net income.

Target Margin: The target margin is the level of net interest margin that aninstitution must earn on its average earning assets in order to reach its desired

return goals.


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Net Interest Change (NIC) Net Interest Change displays how interest income andexpense will change over time, as balances of assets and liabilities naturally re-price,

mature, and rollover into new rate environments. Net interest change is extremely

useful in displaying how changes in market interest rates as well as changes in aninstitutions balance sheet will affect the institutions earnings. The power of net

interest change comes through the analysis of several different rate scenarios at one

time as well as the ability to adjust prepayment speeds for cash flows and monitor

reinvestment assumptions for different interest rate scenarios. Once Net Interest

Change is calculated for each rate scenario, the corresponding net income and

performance measures (return on assets and return on equity) are easily derived.

Summary ALCO Earnings Simulation 12 Month Horizon: This is a key report for management to

gauge future performance under different conditions. IRRM simulates the dynamics of repricing and

maturing balances of assets and liabilities in order to capture the fluctuations in income and expense

under different interest rate scenarios. This requires a variety of behavioral assumptions to be builtinto the model. These assumptions include critical inputs about principal prepayment rates, time

lags, and sensitivities of different types of assets and liabilities to changes in market interest rates.

The output of the simulation shows the projected changes in a number of performance measures

including net interest income, net interest margin, and returns on assets and equity among others.

The IRRM allows for non-parallel yield curve shifts to be modeled as well.


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The EVE concept: Consider the underlying market value of bonds in the investment portfolio. We all

know that if interest rates rise, bond prices fall. This is the manifestation of price risk. What is not as

clear, however, is the degree to which that change in the economic value of the investment portfolio

value will impact the overall value of the balance sheet. Note that loans also have a theoretical

economic value just like bonds. If market interest rates rise sharply, then existing fixed-rate loans will be

worth less from an economic standpoint. Indeed, any financial asset or liability anything with a cashflow will have an underlying value that fluctuates as interest rates move up and down. Whereas the

value of assets will move inversely to interest rates, the value of liabilities will move directly with rates.

This is because existing fixed rate deposits become more valuable to the institution if market interest

rates rise.

The IRRM uses standard financial discounting methodology to derive fair value of assets and liabilities,

then shocks interest rates up and down 100, 200, and 300 basis points, and then recalculates values in

Summary ALCO - Economic Value of Equity (EVE): This is an economic concept that gauges the

impact of interest rate changes on fair market values of asset, liabilities, and equity. EVE capturesthe change in economic value of the bank even though that change may not be reflected in the

banks accounting books and records. This report shows management the capital at risk of the

bank based on the underlying values of all components of the balance sheet. As a measure of

interest rate risk it is separate and distinct from Earnings at Risk.


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order to measure projected changes. The effect of these changes on various equity ratios is reported

along with the percentage change in fair market value for equity among other metrics.

Important to Note -

Benchmarks: The IRRM reports include benchmark or target ranges and ratios for key measures. These

benchmarks are entirely flexible and may be adjusted at managements discretion. The benchmark

targets may serve as policy limits if management so desires, or they may simply serve as strategic targetsseparate and distinct from policy parameters.

Assumptions: Interest rate risk modeling involves projecting (or estimating) behavioral characteristics

which cannot be known with complete precision or certainty. The response and behavior of depositors or

borrowers to a given change in interest rates will vary from one to another and from institution to

institution. For a given bank, we can use historical experience and statistical probabilities to arrive at

reasonable assumptions, but always with the knowledge that these are assumptions about unknowns and

they should be monitored, tested, and adjusted if deemed appropriate. These assumptions include

Reinvestment rates, prepayment rates, sensitivities (or betas) associated with market rate changes, time

lags, direction (or redirection) of maturing balances, and growth rates among others. IRRM includes

default assumptions for all of these but users will need to assess these assumptions and adjust them if

appropriate in order to capture the unique characteristics of the institution.

Back-Testing:Each banks IRRM is back-tested annually to assess modeling efficiency and see how close

the estimates were to actual performance. Actual versus projected changes are compared for different

categories of assets and liabilities. From this, we can determine the accuracy of assumptions. Back-testing

is a critical component of the Asset / Liability Management process as it often results in adjustments or

changes to assumptions in order to improve the process going forward. More information on back-testing

can be found in a separate section of this guide.

Note: Back-Testing is separate and distinct from Validation. Back-testing involves comparing actual

results versus the models projections. Validation involves a detailed analysis of the integrity ofcalculations and methodology of the model itself. The IRRM model has been validated by an outside

auditor and a certification letter of that validation is available to all users.

Other Useful Definitions:

Fully Indexed Yield: This is the yield that would exist on a floating-rate loan or security if the adjustment

were to occur today given the current level of index plus margin and taking into account any caps or

floors. For example, if a floating rate bond has a contractual adjustment of 150 basis points over the one-

year T-Bill, and the one-year T-Bill today is trading at 1%, then the fully indexed yield would be 2.50%. The

fully-indexed yield provides helpful information even for floating rate assets that may not actually adjust

for some time.

Reinvestment Rate (Cap or Floor): Market interest rates are changing daily and banks are constantly

adjusting their loan and deposit rates for new business. The reinvestment rate is simply the newest rate

or yield that would be applied to any given asset or liability if it were to be originated or priced today. The

reinvestment rate cap or floor is the cap or floor that would apply to newly originated assets or liabilities.


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Reset Rate (Cap or Floor): This is the rate on floating- or adjustable-rate assets or liabilities that is calculated

by the contractual formula (index plus margin). The reset rate cap or floor is the cap or floor that is applied to

that principal amount which is resetting.

Note: It is important to recognize the distinction between the cap or floor on re-investing balances on the

one hand, and the cap or floor on resetting principal balances on the other hand. For example, a floating rate

loan may have some portion of principal which is paying down (actual maturing or amortizing dollars) and

another portion which is resetting (dollars of principal which are having their coupon reset or adjusted). Thecap or floor for each of these may be different.


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Modeling the Rate Sensitivity of Non-Maturity Deposits (NMD)

In order to properly measure interest rate risk, we must be able to make reasonable assumptions about

uncertain balance sheet characteristics. One of the most difficult and critical of these assumptions is the

behavior of non-maturity or core deposits in terms of rate sensitivity. We must approximate and

model the frequency with which these deposit balances re-price or mature. The problem is that by their

very nature they have no re-pricing or maturity date. How then do we estimate their rate sensitivity?

Balance Stability:Its difficult to overstate the importance of core deposits to bank performance. Most community banks

hold non-maturity deposits which represent one-third to one-half of their total assets. These are very

low cost funds which are clearly valuable to banks from a net earnings standpoint. Bank customers who

maintain core deposits may do so because of convenience or service, but their balances may also

fluctuate depending on the returns they can earn if they put those dollars to use elsewhere. Some

customers have a preference for liquidity regardless of the opportunity cost, while others are willing to

take greater risk or have less access to immediate cash. Each bank customer has different preferences

and needs. Depositors may add or withdraw funds from these accounts on demand. What ultimately

matters for an asset / liability analyst, though, is the general degree of stability of those deposit

balances.

There are different methods for estimating rate sensitivity of non-maturity deposits. One is to do a

historical study of actual life cycles of accounts. This method looks at when accounts are opened, when

they are closed, and therefore what sort of decay rate is implied. From this we can extrapolate an

average life estimate. An alternative method is to focus on the stability of NMD balances regardless of


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the age, decay, or retention rate of the underlying accounts. This method relies instead on statistical

measures of variance in order to determine how stable NMD balances have been over a time horizon or

an interest rate cycle. The variance of an individual bank can then be compared with the variance of an

appropriate peer group in order to determine whether the banks balances should be modeled with

greater or lesser rate sensitivity. This helps determine the appropriate bucketing percentages which in

turn will lengthen or shorten average life of the NMD. For IRRM clients, this balance stability analysis is

done regularly to determine appropriate modeling assumptions for NMD.

Pricing Behavior:The other important aspect of non-maturity deposits is the price behavior. Core deposits are typically

paid an administered rate. That is to say, the rate for different account-types is established by bank

management and changes relatively infrequently. For most banks, there is a generally weak correlation

between changes in short-term market interest rates (Fed Funds or T-Bills, for example) and the

resulting change in core deposit rates. There may also be long time lags as bank managers wait to assess

the durability of market trends and potential changes in competitive rates. All of this adds up to a

difficult problem for those who must try to model the rate sensitivity of these instruments. Fortunately,

historical pricing data gives us information that allows us to project and model shift sensitivities (betas)

and time lags based on actual observed behavior.


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IRRM: Notes on Methodology & Capabilities

Tax Treatment of Earnings-

The IRRM model produces measures of performance on either a pre-tax or after-tax basis depending on

client preference. As part of the quarterly data input, the bank is asked to provide marginal and effective

tax rates. These rates are then used in calculating and reporting appropriate after-tax income levels in

the IRRM reports. Tax exempt income from municipal bonds is grossed up to reflect the tax-equivalent

yield prior to being imported into IRRM. This process, as with all analytics involving investments, ishandled by the Advanced Portfolio Monitor (APM), an adjunct model to the IRRM itself.

On the supplemental information report, tax-adjusted interest income is reported along with interest

expense and provision for loan losses. The resulting net interest income number then adds non-interest

income and expense to arrive at Operating Income before Gains/Losses, Taxes, and Extraordinary Items.

The last adjustments are Realized Gains/Losses and finally taxes. Adjusted interest income is calculated

using the interest income, tax exempt income, and marginal tax rate.

APM Import into IRRM-

For most community banks, investments represent around one fourth of total assets. The behavior of

investments is often complex with respect to cash flows, price movement, and re-pricing dynamics. For

this reason, the IRRM model relies on a separate module called the Advanced Portfolio Monitor (APM)

to perform investment calculations and analytics. The dynamic cash flows resulting from the APM

Year-to-date income and

expense detail is shown

alongside calculated values

using the Constant Balance

Sheet (CBS) Method. The

CBS values are generally

used as the baseline or

starting point for analysis.


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calculations produce income changes, average lives and durations. This data flows into the IRRM model

alongside the direct data download from the banks general ledger which contains the necessary

information on loans and liabilities. Investments by definition are instantly responsive to market

changes so that the rate shift sensitivities (betas) are 100 percent and time lags are zero. Prepayment

speeds on mortgage-related securities are derived from industry sources, generally Yield Book, and

pulled from APM as well.

Liquidity Stress Tests: IRRM Cash Flow Reports-

Liquidity stress tests involve different aspects of liquidity, some of which can easily be modeled in IRRM.

Specifically, the IRRM produces reports that show the dynamics of balance sheet cash flows under

different rate environments. These are the Principal Cash Flow Scenario Reports which include 12mo

and 24mo horizons and a variety of different rate scenarios.

It should be noted, however, that liquidity stress tests also refer to things like what would the bank do

if a large employer in the community shut down and deposits dropped sharpl y or what would the

bank do if they could no longer access certain lines of credit that they previously had? These are things

that are not modeled in IRRM, but can be incorporated into a liquidity report (such as a simple

spreadsheet) that includes the dynamic cash flows from IRRM.

Back-Testing-

Back Testing is the process of reviewing the projections of an A/L model after the fact and comparingthose projections against actual performance. It is much like the budgeting process where we track

budgeted versus actual results over a given time period. In the case of A/L back testing, we see whether

and to what degree the model gave an accurate projection of bank performance, particularly with

respect to interest rate risk. With the results of a back test, we can ask:

1. Were our projections different from actual bank performance?2. If so, by how much? And

IRRM produces a variety of dynamic cash flow reports which can

be helpful input for banks that prepare internal liquidity reports.


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3. What inputs, assumptions, or dynamics might explain the variance (e.g. time lags, thecompetitive environment, changes in the local economy, etc)?

The ultimate objective of a back test is to give guidance as to if and how management might want to

adjust current assumptions within the A/L model in order to more accurately represent the performance

trends of the bank. A back test, unlike model validation (which is a distinctly different process), does not

need to be performed by an outside auditor. The back test may be done internally or with support from

the vendor or model provider. In either case, back testing should be performed, assumptions should be

reviewed, and adjustments should be made when necessary. Ideally we want to drill down to specificcategories of assets and liabilities to see where projections were high or low, and scrutinize the

assumptions that are applied to those categories.

The back-test assesses the accuracy of model projections by comparing the results of a

previously run IRRM report with actual results. The purpose of this exercise is to test the

reasonableness of assumptions and make adjustments where necessary.


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Budgeting -

There is an important distinction to be made between the budgeting process and interest rate risk

management. Budgeting involves the estimation of growth in different accounts and categories of assets

and liabilities, and the resulting income and expense projections. The development of an annual budget

and the monthly tracking of variance (actual balances and levels versus budgeted balances and levels) is

an important component of strategy development for any bank. The budget process also produces keyinputs that go into the IRRM model. Specifically, the budgeted non-interest income and expense items,

provision for loan losses, and any one-time income or expense events that are expected to occur can be

incorporated into the baseline Constant Balance Sheet projections.

IRRM is a dynamic interest rate risk model, not a budgeting program.However, critical information that is used in the budgeting process

can be found in the Average Balance and Rates report among others.


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Dynamic Simulation Capabilities (Growth, A/L Mix) -

In addition to staticsimulation analysis which is required by regulators, the IRRM can model a variety of

balance sheet dynamics such as growth and sector re-allocation. During the course of a year, a banks

balance sheet may change dramatically. Loans may grow, investments may shrink, and the mix of

deposits may change through over the course of time. This may be due to execution of the banksstrategy or marketing plan, plus general economic conditions in the community served. All of these

things can be modeled in IRRM.

Disclaimer: Information herein is believed to be reliable but The Baker Group does not guarantee its completeness or accuracy.

Opinions constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.

This report is for informational purposes only. Actual results achieved during the projection period may vary from projections.

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument.

The Balance Sheet Projection

report, found in the Summary

Board Packet, shows the change

in book balances due to

projected growth or mix

adjustments. These reports

show the change over 12mo or

24mo time horizons.


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Data Input and Assumptions for Interest Rate Risk Monitor (IRRM)

Computer simulations are used to project the performance of complex systems under varying

conditions. In banks, an asset / liability management model is used to capture the dynamics of a banksbalance sheet and to project financial performance under different interest rate environments. As with

any model, the input and assumptions that are built into the framework are critical to the integrity of

the resulting output. From the standpoint of management efficiency, a good model should produce

reports that detail the key inputs and assumptions.

The IRRM model produces three important reports containing information about data input and

assumptions. These reports are designed for managements use as well as for regulatory compliance.

Below is a list of those key reports:

Reinvestment Rates Detail Report this report lists every category of asset and liability.Information for each item includes:

o the current balance (book value)o the current book yield (or rate)o the fully indexed yield (FIY) for adjustable, variable or floating rate instruments


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o the cap or floor for adjustable, variable, or floating rate instrumentso the cap or floor for reinvested principal or new moneyo the weighted average reinvestment rate (this is the banks average current offering rate

for new money)

o columns for three alternative re-investment options which show any re-allocation of re-investing balances within the same account

o a column showing any balances that may roll into another asset or liability category Rate Shift Assumptions Report this report shows various behavioral assumptions across

different interest rate environments for each category of asset and liability. The rate

environments are user-defined and flexible. They may include instantaneous rate shocks, rate

shifts over a time horizon, parallel shifts or non-parallel shifts. (a bias for rates may also be set as

a starting point when banks know that a pricing change is imminent). Normally, the base case is

simply for no change over a 12 month horizon. The other assumptions that vary include:

o CPR Projection this is the assumption for speed of principal return that is assigned toamortizing assets and liabilities

o Shift Sensitivity this is the category-specific sensitivity (or beta) that corresponds toeach rate scenario

o Time Lag this is the category-specific time lag applied to the pricing change for eachrate scenario

o Reinvestment Rate (1yr) this is the reinvestment rate for the account that will existafter one year given the time lags and shift sensitivities


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o Average Life this is the average length of time that each dollar of principal isoutstanding

o There are also rows for additional information about reinvestment of principal (threeoptions)

Balance and Rate Entry Report this report details cash flows and associated yields or ratesmonth-over-month (or per defined period) for each category of asset and liability. It breaks

down cash flows into maturing dollars versus principal paydowns as well as variable or floating

rate adjustments to principal dollars. Each cash flow balance has the appropriate yield or rateassociated with it in each time period. There is also information on this report regarding caps

and floors associated with the account, the current fair market value, the discount rate used for

EVE calculations, average life, modified and effective durations, and the effective convexity

among other things.

Supplemental Information ReportIn order for projected changes in interest income and expense to translate into bottom-line

performance, we need to have some idea of what the bank is expecting in terms of non-interest income

and expense as well as provision for loan losses and taxes. This data must be provided by the bank as

supplemental input in order for the IRRM to establish a baseline measure of performance. Once this


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baseline is established, changes in interest income and expense can be applied to arrive at projected

performance over the different interest rate environments.

There are two methods for establishing the baseline (base case) net income. One method is simply to

annualize the year-to-date performance. Another is to calculate projected interest income and expense

based on actual balances and rates that exist on the balance sheet as of report date. In this latter case,

we still need projections or estimates (from bank management) for the non-interest items, provision for

loan loss, and taxes. Unless we tell the model otherwise, it will simply default to the actual year-to-date

numbers for those projections. This report also includes information on the rate of dividend payout(where applicable) and OREO.






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Basics of Interest Rate Risk & Asset / Liability Management

A Primer for Community Bank Directors

Introduction:

The successful performance of a community bank ultimately depends on proper understanding and

management of interest rate risk (IRR). Recent regulatory communications have emphasized the

importance of board education on IRR issues along with sound and thorough processes for IRR

management. This document provides essential explanations and definitions of the basics of interest

rate risk and is designed for community bank directors.

Interest Rate Risk (IRR) is the risk to earnings or capital that arises from changing interest rates and the

resulting impact on a banks balance sheet. Every day, the bank experiences inflows and outflows of

deposits, loans, and investments. Those dollars come in and go out of the balance sheet in many forms.

New money is deposited, loans are re-paid, bonds mature, new loans are made, deposits leave,adjustable loans re-price there is clearly a lot involved in the daily dynamics of a bank balance sheet.

Meanwhile, in the midst of this dynamic swirl, interest rates are changing in different ways on different

types of loans, deposits, and investments.

In order to manage interest rate risk, we must have policies procedures and reporting tools to help us

define, measure, and manage the dynamics of the balance sheet in the face of changing interest rates.

The comprehensive process of managing IRR within the context of the overall bank is often referred to

as Asset / Liability Management or ALM. The internal committee which is responsible for IRR

management is usually referred to as the Asset / Liability committee or ALCO.

Reporting systems that give us information about interest rate risk exposures generally rely on three

primary methods: GAP analysis, Earnings Simulation, and Economic Value analysis. These three methodswill be explained below.

Components of IRR:

Interest rate risk can be broken down into four basic components:

Re-pricing risk

The risk presented by assets and liabilities that re-price at different times and rates. For example, a loan

with a variable rate will generate more interest income when rates rise and less interest income when

rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.

Basis risk

The risk presented when yields on assets and costs on liabilities are pegged to different bases, such as

the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different

bases will move at different rates or in different directions, which can cause erratic changes in revenues

and expenses.


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Yield curve risk

The risk presented by differences between short-term and long-term interest rates. Short-term rates are

normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower

rates) and investing in long-term assets (at higher rates). But the relationship between short-term and

long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and

expenses.

Option risk

Option risk entails uncertainty of cash flow. For example, the bank may purchase a bond which has a fiveyear maturity, but it contains an option whereby the issuer of the bond may call it in early, say after one

year. In this example, there is uncertainty as to whether the bank will have its principal returned in five

years or in one year. This uncertainty is due to options risk. Similarly, if a mortgage loan customer

decides to re-finance their loan prior to the scheduled maturity that loan customer is exercising an

option to re-finance. Again, this results in earlier return of principal than would otherwise be the case.

There a variety of other examples of options risk in bank balance sheets and they all entail cash flow

uncertainty. Option risk can be difficult to measure and control.

Measuring Interest Rate Risk:

GAP Analysis

Gap is simply the dollar difference between rate sensitive assets (i.e. assets that re-price or mature) and

rate sensitive liabilities for a particular time period, usually 12 months. If more assets re-price than

liabilities, the number will be positive which shows that an institution is asset sensitive, or positively

gapped. Traditional Gap theory says that an asset sensitive institution will generally realize an increase

in income if interest rates rise due to the fact that more assets than liabilities will be rolling over and re-

pricing into higher market rates. In this case, all else being equal, earning asset yield will rise faster than

the cost of liabilities. The exact opposite takes place if the bank has a negative Gap, where more

liabilities than assets re-price during the period. It is important to note that Gap analysis deals only with

balances of rate sensitive assets and liabilities, and ignores the rates (yields or costs) associated with

those re-pricing balances. It is therefore only a crude indicator of the potential change in net income.

Effective Gap versus Re-pricing Gap: One of the problems with Gap measures involves the treatment of

non-maturing deposits. These liability accounts (such as Checking, Savings, and MMDA) do not have an

identifiable maturity date and contractually the rate may be changed by the bank any time it chooses.

So there arises a question as to whether these items should be treated as always and immediately rate

sensitive, or if they should be assigned a rate sensitivity that more accurately reflects their true

behavior.

Re-pricing Gap is defined as a gap measure that utilizes contractual re-pricing dates in the allocation of

assets and liabilities across predefined time periods. A re-pricing gap treats non-maturing deposits as

though they will immediately and instantly re-price each time market rates move. Re-pricing Gap does

not consider the actual behavior of non-maturing deposits in terms of how they affect the balancesheet.

Effective Gap is a more useful measure for rate sensitivity analysis. Effective gap uses behavioral

assumptions that more accurately model the rate sensitivity of non-maturing deposits. Effective Gap is

considered to be the more meaningful measure for analysis since it looks at the true behavior of non-

maturing deposits rather than the contractual ability to re-price. The IRRM uses FDICIA 305 guidelines as

a default treatment of non-maturing deposits in order to arrive at the Effective GAP.


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Treatment of Non-Maturity Deposits: Most banks have a large percentage of their liabilities in core

deposits or non-maturity deposits (DDA, NOW, and MMDA). These liabilities are difficult to model with

respect to rate sensitivity and re-pricing behavior. The rates paid on Core deposits are generally

considered to be administered rates in the sense that they set or changed at anytime at the discretion

of bank management. Often, core deposit rates are barely moved for lengthy periods of time, but to

some degree bank managers will move these rates according to changes in the general interest rate

environment. Every bank is different in this respect. In order to model these deposits appropriately, we

must use some sort of guidelines for estimating how rate sensitive these accounts are likely to be. As abase case default, a bank may use the guidelines originally proposed in section 305 of the FDIC

Improvement Act of 1991 (FDICIA). These guidelines provide for a percentage of the balance in different

non-maturing deposit accounts to be treated as re-priceable or rate sensitive across a range of maturity

buckets. This scheme of maturity distribution is shown in the table below.

FDICIA 305: Maturity Distribution Limits for Non-Maturity Deposits

----------------------------------------------------------------------------------------------------------------

0-3 mos 3-12 mos 1-3 yrs 3-5 yrs 5-10 yrs

(pct) (pct) (pct) (pct) (pct)---------------------------------------------------------------------------------------------------------------

Commercial DDA.... 50 0 30 20 .....

Retail DDA............... 0 0 60 20 20

MMDA.................... 0 50 50 ..... .....

Savings.................... 0 0 60 20 20

NOW....................... 0 0 60 20 20

----------------------------------------------------------------------------------------------------------------

This treatment of non-maturity deposits will result in average life and duration measures that are

greater than zero, but still fall within reasonable ranges for analysis of economic value. It is important to

note that the FDICIA guidelines are a default and are not intended to replace the need for banks to

evaluate and consider the unique characteristics of their individual deposit bases when determining

their rate sensitivity.

Earning Simulation Analysis:

Its always important to remember that the margins and earnings being reported today are a reflection

of the loans that were made and bonds that were purchased years ago, along with deposits that were

priced months ago. Bank managers must be aware that everything they do today with respect to pricing

loans and liabilities or choosing securities for purchase is going to have an impact on the income

statement at some point in the future. All of this points to the importance of forward-thinking analysisand the simulation of future expected trends. As discussed previously, bank balance sheets are

constantly changing as the volumes of different asset and liability accounts, the rates paid (or earned)

on those balances and the cash flows moving into and out of those accounts are increasingly dynamic

and unpredictable. What we need to know is, given the current mix of assets and liabilities and the rates

associated with them, how can we expect margins and earnings to perform as the dynamics of re-pricing

assets and liabilities filter through the balance sheet over time? This is what earnings simulation analysis

is all about.


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In order to do this analysis, we must have essential balance sheet data pulled into the model. We begin

with an electronic import of the balances of assets and liabilities, the re-pricing or maturing schedules of

those balances, and the rates you are earning or paying on those balances. We then input re-investment

rates and other assumptions (for example, estimates of how fast principle will prepay above and beyond

what is scheduled). Then we simply ask the model to calculate how the dynamics of re-pricing and rate

changes will filter through into interest income, interest expense, and net-interest income.

In general, earnings simulation models are more dynamic than gap analyses and market valuationsimulations. Whereas gap and market valuation models generally take a snapshot of the risk inherent

in a banks balance sheet structure at a particular point in time, most earnings simulation models

evaluate risk exposure over a period of time, taking into account projected changes in balance sheet

structures, pricing, and maturity relationships, and assumptions about new business. Banks often use

simulation models to analyze alternative business decisions and to test the effect of those decisions on a

banks risk profile before implementation. Banks also use simulation models in budgeting and profit

planning processes.

Economic Value of Equity:

Economic value of equity (EVE) is a concept that gauges the impact of interest rate changes on fairmarket values of asset, liabilities, and equity. EVE captures the change in economic value of the bank

even though that change may not be reflected in the banks accounting books and records. Consider the

underlying market value of bonds in the investment portfolio. We all know that if interest rates rise,

bond prices fall. This is the manifestation of price risk. What is not as clear, however, is the degree to

which that change in the economic value of the investment portfolio value will impact the overall value

of the balance sheet. Note that loans also have a theoretical economic value just like bonds. If market

interest rates rise sharply, then existing fixed-rate loans will be worth less from an economic standpoint.

Indeed, any financial asset or liability anything with a cash flow will have an underlying value that

fluctuates as interest rates move up and down. Whereas the value of assets will move inversely to

interest rates, the value of liabilities will move directly with rates. This is because existing fixed rate

deposits become more valuable to the institution if market interest rates rise. A good IRR model will use

standard financial discounting methodology to derive fair value of assets and liabilities, then shock

interest rates up and down 100, 200, and 300 basis points, and recalculate values in order to measure

projected changes. The effect of these changes on various equity ratios is reported along with the

percentage change in fair market value for equity among other metrics.






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Regulatory Guidance: Interest Rate Risk

FFIEC Advisory on Interest Rate Risk Management Jan. 2010: Abridged Version

1. Corporate Governancea. Directors should understand and be regularly informed about the level and trend of

their of their institutions IRR exposure.b. Senior management is responsible for ensuring that board-approved strategies, policies,

and procedures for managing IRR are appropriately executed.

i. Appropriate policies, procedures and internal controlsii. Comprehensive systems and standards for measuring IRRiii. Sufficiently detailed reporting processes

2. Policies and Procedures-a. Policies should address the potential impact of changing interest rates on earnings and

capital

b. Policies should specify IRR tolerances in the context of scenarios of potential changes inmarket interest rates and a target or range for performance metrics.

3. Measurement and Monitoring of IRR-a. Institutions expected to have robust IRR measurement processes (commensurate with

the size and complexity of the institution)

b. Institutions expected to fully understand the underlying analytics, assumptions, andmethodologies and ensure such systems and processes are incorporated appropriately

in the strategic (long-term) and tactical (short-term) management of IRR exposures.

c. Measurement Methodologies i. Primarily use simulations to assess the impact of changing rates on earnings and

capital

ii. Run static simulations to provide ALCO or senior management a complete andcomparative description of the institutions IRR exposure.

iii. Economic Value (EVE) methodologies should also be which capture all futurecash flows expected from existing assets and liabilities, and is more effective in

considering embedded options in a typical institutions portfolio.

An institutions IRR measurement system should be sufficiently robust to capture all material on and off-

balance sheet positions and incorporate a stress-testing process to identify and quantify the institutions

IRR exposure.

d. Stress Testing-i. Regularly assess IRR exposures beyond typical industry conventions, including

changes in rates of greater magnitude (e.g. up and down 300 and 400 basis

points) across different tenors to reflect changing slopes and twists of the yieldcurve.

ii. In low-rate environments, scenarios involving significant declines in marketrates can be deemphasized in favor of increasing the number and size of

alternative rising-rate scenarios.

iii. Include instantaneous shocks, non-parallel curve changes, and basis risk instress scenarios


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e. Assumptions-i. Regularly assess the reasonableness of assumptions document, monitor, and

update key assumptions.

ii. Assumptions about non-maturity deposits are critical.1. Generally, rate-sensitive and higher-cost deposits, such as brokered and

Internet deposits, would reflect higher decay rates than other types of

deposits.

iii. Sensitivity testing of key assumptions that exert the greatest impact onmeasurement results. When actual experience differs from past assumptionsand expectations, institutions should use a range of assumptions to

appropriately reflect this uncertainty.

4. Internal Controls and Validation-a. Validation of IRR model is fundamental

i. Credible third-party should test the mechanics and mathematics of themeasurement model.

ii. Independent review (may be an internal audit at smaller banks) assessing thebanks process for IRR measurement (including reasonableness of assumptions

and back-testing) to ensure the integrity of risk management process.





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